The Risks of Subsidies in Small Economies and Their Geopolitical Impact

When I began writing this article, AKD was not the president and had not given any subsidies. However, last night he started providing subsidies to farmers and fishermen. I acknowledge that these sectors have been hampered by the economic downturn and are suffering.

Fertilizer subsidies for farmers began in 1962. The governments discontinued these subsidies in 1989, but they resumed in 1994. These subsidies were incorporated into the political program. Government spending increased from approximately 10.6 billion Lkr in 2006 to 50 billion Lkr in 2012. Was agriculture improved? This is tax payer money or printed money (inflationary tax). Has agriculture embraced technology? These are important questions that we must ask. It is irreversible to play politics in a situation such as this one in Sri Lanka. However, we'll have to wait and see if the new president is just playing politics or if his actions were truly intended to boost the economy.

There are more than 2.8 million farmers in Sri Lanka, and for decades they have received subsidies. Yet their contribution to the economy remains less than 3%. I am not criticizing the new president's policies; I am merely highlighting my point of view on this matter.

Given the recent changes, these subsidies may also be subject to modification. However, we need to ask whether these subsidies are sustainable or if they are politically motivated due to the upcoming election. Anyhow, the election commission has temporarily stopped this subsidy due to the upcoming parliamentary election.?

Now let's dive into the main topic.

In many small countries, subsidies are seen as a tool to support key sectors, protect vulnerable communities, and stabilize the economy in times of crisis. However, while subsidies might provide short-term relief, they often create long-term challenges, especially in small economies. These challenges are not only economic but also have significant geopolitical implications.

1.Economic Strain on Government Finances

One of the primary reasons why subsidies can be detrimental in small countries is the strain they put on government finances. Small economies generally have limited revenue streams and a smaller tax base. This makes it difficult to fund subsidies without accumulating debt or redirecting funds from critical sectors such as education, healthcare, and infrastructure.

In the case of Sri Lanka, for example, increasing fertilizer and fisher subsidies would add pressure to an already fragile fiscal situation. The government has limited resources, and subsidizing key sectors often leads to a higher fiscal deficit. With debt already mounting, small countries that rely on borrowing to fund subsidies find themselves stuck in a cycle of increasing debt obligations, which can destabilize the economy and affect their international credit ratings.

2. Inflationary Pressures and Economic Distortion

Subsidies can distort the natural functioning of markets. In a small economy, where market forces are more fragile, these distortions can lead to severe inefficiencies. For instance, excessive subsidies for fertilizers or fuel can encourage overuse, reducing productivity over time. The market becomes dependent on government support, making sectors such as agriculture or fisheries less competitive and less adaptive to technological changes.

Moreover, when subsidies are withdrawn due to fiscal constraints, price shocks can occur, causing inflation. These inflationary pressures hit low-income households the hardest, creating social unrest and political instability. Small countries that cannot afford inflationary spirals may find it difficult to stabilize their economy without external assistance.

3. Environmental Degradation

Subsidies can have severe environmental impacts, particularly in small, resource-dependent countries. Fertilizer subsidies, for example, may lead to overuse, which degrades soil health and pollutes water sources. Overfishing, fueled by cheap fuel subsidies, can result in the depletion of marine life, harming ecosystems and reducing long-term economic prospects for coastal communities.

Environmental degradation not only impacts the economy but also diminishes a country’s standing on the global stage. Countries perceived as failing to protect their natural resources may face international pressure, particularly from environmental groups or foreign governments that promote sustainable development.

4. Geopolitical Implications

Subsidies, particularly in small countries, can also have broader geopolitical consequences. Many small countries are heavily reliant on external aid or financial assistance from international organizations like the International Monetary Fund (IMF), the World Bank, or even powerful regional neighbors. By implementing subsidies, particularly unsustainable ones, small nations may find themselves violating agreements with these institutions or lenders. For example, Sri Lanka has had to negotiate multiple times with the IMF for economic support. A commitment to reducing subsidies is often a key part of these agreements to ensure fiscal discipline and reduce reliance on external borrowing. Increasing subsidies can signal poor financial governance, potentially jeopardizing relations with international lenders or leading to reduced foreign investments.

Subsidies can also become a geopolitical tool for larger powers to exert influence over smaller countries. Nations that provide financial assistance or subsidized products—such as fuel or food—can leverage these dependencies to push for favorable diplomatic or trade agreements. Small countries may find themselves politically tied to major powers in return for economic assistance. In the case of Sri Lanka, reliance on Chinese loans and investments, especially in projects like the Hambantota Port, has led to accusations of "debt-trap diplomacy," where political and territorial sovereignty becomes increasingly compromised.

5. Vulnerability to Global Market Fluctuations

Small economies are often highly dependent on imports, which means they are vulnerable to global market fluctuations. When a government subsidizes certain goods, such as food or fuel, it assumes the cost of maintaining these goods at an artificially low price. However, if global prices rise—whether due to geopolitical tensions, conflicts, or supply chain disruptions—small countries will struggle to maintain subsidies without significantly increasing their expenditure.

For instance, fuel subsidies are often subject to global oil price fluctuations. A sudden spike in global oil prices can cause a fiscal crisis for a small nation reliant on these subsidies. This makes the country even more vulnerable to external pressures, both economically and diplomatically.

Due to the ongoing conflict between Israel and Palestine, which has now expanded to include Lebanon, Iran, and Israel, The price of crude oil has increased globally from 3% on the day I published the post, with the Middle East region and Israel experiencing a full-scale conflict.

6. Undermining Competitiveness and Innovation

One of the long-term drawbacks of subsidies is that they undermine the competitiveness of key sectors. When businesses or industries receive continuous government support, they have less incentive to innovate or become more efficient. This is particularly damaging for small economies that rely on exports or specific industries, such as tourism, agriculture, or fisheries.

If small countries focus too much on subsidizing traditional sectors, they may lose out on opportunities to diversify their economy and attract foreign investment. This lack of innovation stunts economic growth and makes the country more vulnerable to global competition. In addition, reliance on subsidies can lead to trade tensions or tariff impositions from larger nations, particularly if subsidies are viewed as market-distorting. While subsidies can provide short-term relief to specific sectors or vulnerable populations, their long-term consequences are particularly severe for small economies. The strain on government finances, market inefficiencies, environmental degradation, and geopolitical vulnerabilities all contribute to making subsidies a risky policy tool.

With current regional developments, we need to be more open and competitive. By relying on subsidies, we will never achieve this goal. For instance, Indonesia has recently joined the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). They reformed their government and opened their markets to allow free capital flow, which will attract more Foreign Direct Investments (FDIs).

As a country, we need to follow suit. We are not isolated on the global stage but a part of it. In my opinion, we need to be more pragmatic about capitalism rather than continuing to run a welfare state. While I agree that we need to protect our vulnerable communities and farmers, they also need to become competitive. By giving subsidies, I believe we inadvertently make these people more vulnerable. Governments need to protect people, sometimes even from themselves.

I can provide numerous examples from the region where governments have reduced their size, opened markets, and significantly decreased subsidy systems. Another example is Vietnam: on the 26th, they announced that Samsung is investing $1.5 billion in the country. Meanwhile, we receive a $2.9 billion bailout from the IMF. We are competing with these countries. So, as an observer and an International Relations enthusiast, I ask my readers: Are we on the right path?

Small countries like Sri Lanka need to carefully balance their domestic economic needs with their international obligations and geopolitical realities. In a world where international financial institutions and powerful nations closely monitor fiscal policies, maintaining unsustainable subsidies can harm both the economy and the country's standing on the global stage. Instead of focusing on subsidies, small nations should prioritize sustainable development, economic diversification, and innovation to ensure long-term growth and geopolitical stability.

"When private enterprise fails it close down but when a Government enterprise fails it is expanded, isn't that exactly happens with drugs?"

-Milton Friedman-